Publicly Funded Inequality

By Kemal Derviş, a co-author of the “22 Ideas to Fix the World”, Brookings, March 9, 2015

One of the factors driving the massive rise in global inequality and the concentration of wealth at the very top of the income distribution is the interplay between innovation and global markets. In the hands of a capable entrepreneur, a technological breakthrough can be worth billions of dollars, owing to regulatory protections and the winner-take-all nature of global markets. What is often overlooked, however, is the role that public money plays in creating this modern concentration of private wealth.

As the development economist Dani Rodrik recently pointed out, much of the basic investment in new technologies in the United States has been financed with public funds. The funding can be direct, through institutions like the Defense Department or the National Institutes of Health (NIH), or indirect, via tax breaks, procurement practices, and subsidies to academic labs or research centers.

When a research avenue hits a dead end – as many inevitably do – the public sector bears the cost. For those that yield fruit, however, the situation is often very different. Once a new technology is established, private entrepreneurs, with the help of venture capital, adapt it to global market demand, build temporary or long-term monopoly positions, and thereby capture large profits. The government, which bore the burden of a large part of its development, sees little or no return.

One example, flagged by the economist Jeffrey Sachs, is Sovaldi, a drug used to cure hepatitis C. As Sachs explains, the company that sells it, Gilead Sciences, holds a patent for the treatment that will not expire until 2028. As a result, Gilead can charge monopoly prices: $84,000 for a 12-week course of treatment, far more than the few hundred dollars it costs to produce the drug. Last year, sales of Sovaldi and Harvoni – another drug the company sells for $94,000 – amounted to $12.4 billion.

Sachs estimates that the private sector spent less than $500 million on research and development to develop Sovaldi – an amount that Gilead was able to recoup in a few weeks of sales. The NIH and the US Department of Veterans Affairs, however, had heavily funded the start-up that developed the drug and was later acquired by Gilead.

There can be no doubting that the imagination, marketing savvy, and management skills of private entrepreneurs are critical to the successful application of a new technology. And the lower prices, better products, and consumer surplus provided by the commercialization of many innovations clearly provide large societal gains. But one should not overlook the role of government in these successes.

Joint OECD-Eurostat data show that direct government expenditures accounted for 31% of R&D spending in the US in 2012. Adding indirect expenditures, like tax breaks, would bring this figure to at least 35%. Thanks to such public outlays, a few private players are often making huge returns, which are a major cause of excessive income concentration.

There are several ways to change such a system. Rodrik proposes the creation of public venture capital firms – sovereign wealth funds – that take equity positions in exchange for the intellectual advances created through public financing. Another solution would be to reform the tax code to reduce returns when an individual or firm is cashing in on publicly funded research.

Both solutions face difficulties. Sovereign wealth funds would have to be shielded from partisan politics, perhaps by giving them only non-voting shares. Raising taxes on the beneficiaries of publicly funded research would be a challenge, given that the link between an original breakthrough and the wealth it created might be hard to quantify. There is also the complication of global capital mobility and tax avoidance, which the G-20 is only beginning to address.

Other approaches are also possible: tightening up patent laws or imposing price controls for monopolistic industries, such as pharmaceuticals, as many market economies have done. What would not be a solution, however, would be to channel fewer public resources into research and innovation – key drivers of economic growth.

It does not take huge rates of returns to mobilize a lot of talent; something like a 50% profit margin for a few years would be an acceptable reward for particularly good entrepreneurship. Multiples of that amount, however, simply end up as gifts by the public to a few individuals. A combination of measures and international agreements must be found that would allow taxpayers to obtain decent returns on their investments, without removing the incentives for savvy entrepreneurs to commercialize innovative products.

The seriousness of this problem should not be understated. The amounts involved contribute to the creation of a new aristocracy that can pass on its wealth through inheritance. If huge sums can be spent to protect privilege by financing election campaigns (as is now the case in the US), the implications of this problem, for both democracy and long-term economic efficiency, could become systemic. The possible solutions are far from simple, but they are well worth seeking.